Wednesday, December 26, 2012

Japan's New Inflationary Strategy

Japan has during the latest decade lagged most countries in GDP growth and it has also had low but relatively persistent price deflation. This has by some been interpreted as evidence that even low levels of deflation is harmful to the economy.

However, if you adjust for population growth, Japanese growth has actually been in line with U.S. growth and somewhat higher than the average for Western Europe. And if you further adjust for the fact that Japan's population is aging much faster than elsewhere, growth has actually been higher. Total GDP may have grown slower, but GDP relative to its working age population has been growing somewhat faster than the average for rich countries.

This didn't stop Japanese voters from electing a new government that promised to create at least 2% in yearly inflation and has threatened to remove the Bank of Japan's formal independence unless it does a lot more to inflate. Since an "independence" that depends on it following orders isn't really independence, this means that the Bank of Japan's independence has in effect already been abolished.

One interesting aspect of this is that it shows that merely by creating expectations of more inflation, you can create it. During the latest month the yen has fallen by 4% against the U.S. dollar, by 5% against British pound and the South Korean won (I've included the won because South Korea is Japan's most important competitor in its export markets) and by more than 6% against the euro.
Compared to a year earlier, the declines are even more dramatic, falling by nearly 10% against the dollar, by more than 10% against the pound and the euro and by more than 15% against the won.

By raising import prices and raising nominal export revenues this will raise price inflation and nominal GDP. However, real GDP won't be increased other than at best temporarily, because prices are likely to increase about the same as nominal GDP.

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